It's only when the tide goes out that you learn who has been swimming naked.
- Warren Buffett, credit Old School Value
When I was 29, nearly half a life ago, Donald Trump was a struggling real estate developer. In 1990, I was still trying to develop my own views of the economy and finance. But one day heading home from work at AIG (NYSE:AIG), I was listening to the business report on the radio, and I heard the announcer say that Donald Trump had said that he would be "the king of cash." My tart comment was, "Yeah, right."
At that point in time, I knew that a lot of different entities were in need of financing. Though the stock market had come back from the panic of 1987, many entities had overborrowed to buy commercial real estate. The major insurance companies of that period were deeply at fault in this as well, largely driven by the need to issue 5-year Guaranteed Investment Contracts (GICs) to rapidly growing stable value funds of defined contribution plans. Outside of some curmudgeons in commercial mortgage lending departments, few recognized that writing 5-year mortgages with low principal amortization rates against long-lived commercial properties was a recipe for disaster. This was especially true as lending yield spreads grew tighter and tighter.
(Aside: the real estate area of Provident Mutual avoided most of the troubles, as they sold their building that they built seven years earlier for twice what they paid to a larger competitor. They also focused their mortgage lending on small, ugly, economically necessary properties, and not large trophy properties. They were unsung heroes of the company, and their reward was elimination eight years later as a "cost-saving move." At a later point in time, I talked with the lending group at StanCorp (NYSE:SFG), which had a similar philosophy, and expressed admiration for the commercial mortgage group at Provident Mutual… StanCorp saw the strength in the idea, and still follows it today as the subsidiary of a Japanese firm. But I digress…)
Many of the insurance companies making the marginal commercial mortgage loans had come to AIG seeking emergency financing. My boss at AIG got wind of the fact that I was looking elsewhere for work, and subtly regaled me of the tales of woe at many of the insurance companies with these lending issues, including one at which I had recently interviewed. (That was too coincidental for me not to note, particularly as a colleague in another division asked me how the search was going. All this from one stray comment to an actuary I met coming back from the interview…)
Back to the main topic: good investing and business rely on the concept of a margin of safety. There will be problems in any business plan. Who has enough wherewithal to overcome those challenges? Plans where everything has to go right in order to succeed will most likely fail.
With Trump back in 1990, the goal was admirable - become liquid in order to purchase properties that were now at bargain prices. As was said in the Wall Street Journal back in April of 1990, the article started:
In a two-hour interview, Mr. Trump explained that he is raising cash today so he can scoop up bargains in a year or two, after the real estate market shakes out. Such an approach worked for him a decade ago when he bet big that New York City's economy would rebound, and developed the Trump Tower, Grand Hyatt and other projects.
"What I want to do is go and bargain hunt," he said. "I want to be king of cash."
That's where Trump said it first. After that he received many questions from reporters and creditors, because his businesses were heavily indebted, and property values were deflated, including the properties that he owned. Who wouldn't want to be the "king of cash" then? But to be in that position would mean having sold something when times were good, then sitting on the cash. Not only is that not in Trump's nature, it is not in the nature of most to do that. During good times, the extra cash that Buffett keeps on hand looks stupid.
Trump did not get out of the mess by raising cash, but by working out a deal with his creditors in bankruptcy. Give Trump credit, he had convinced most of his creditors that they were better off continuing to finance him rather than foreclose, because the Trump name made the properties more valuable. Had the creditors called his bluff, Trump would have lost a lot, possibly to the point where we wouldn't be hearing much about him today.
Trump escaped, but most other debtors don't get the same treatment Trump did. The only way to survive in a credit crunch is plan ahead by getting adequate long-term financing (equity and long-term debt), and keep a "war kitty" of cash on the side.
During 2002, I had the chance to test this as a bond manager. With the accounting disasters at mid-year, on July 27th, two of my best brokers called me and said, "The market is offered without bid. We've never seen it this bad. What do you want to do?" I kept a supply of liquidity on hand for situations like this, so with the S&P falling, and the VIX over 50, I put out a series of lowball bids for BBB assets that our analysts liked. By noon, I had used up all of my liquidity, but the market was turning. On October 9th, the same thing happened, but this time I had a larger war chest, and made more bids, with largely the same result.
That's tough to do, and my client pushed me on the "extra cash sitting around." After all, times are good, there is business to be done, and we could use the additional interest to make the estimates next quarter.
To give another example, we have the visionary businessman Elon Musk facing a cash crunch at Tesla (NASDAQ:TSLA) and SolarCity (SCTY). Leave aside for a moment his efforts to merge the two firms when stockholders tend to prefer "pure play" firms to conglomerates - it's interesting to look at how two "growth companies" are facing a challenge raising funds at a time when the stock market is near all-time highs.
Both Tesla and SolarCity are needy companies when it comes to financing. They need a lot of capital to grow their operations before the day comes when they are both profitable and cash flow from operations is positive. But, so did a lot of dot-com companies in 1998-2000, of which a small number exist to this day. Elon Musk is in a better position in that presently he can dilute issue shares of Tesla to finance matters, as well as buy 80% of the SolarCity bond issue. But it feels weird to have to finance something in less than a public way.
There are other calls on cash in the markets today - many companies are increasing dividends and buying back stock. Some are using debt to facilitate this. I look at the major oil companies and they all seem to be levering up, which is unusual given the recent trajectory of crude oil prices.
We are in the fourth phase of the credit cycle now - borrowing is growing, and profits aren't. There's no rule that says we have to go through a bear market in credit before that happens, but that is the ordinary way that excesses get purged.
That is why I am telling you to pull back on risk, and review your portfolio for companies that need financing in the next three years or they will croak. If they don't self-finance, be wary. When things are bad, only cash flow can validate an asset, not hopes of future growth.
With that, I close this article with a poem that I saw as a graduate student outside the door of the professor for whom I was a teaching assistant when I first came to UC-Davis. I did not know that is out on the web until today. It deserves to be a classic:
Once upon a midnight dreary as I pondered weak and weary
Over many a quaint and curious volume of accounting lore,
Seeking gimmicks (without scruple) to squeeze through
Some new tax loophole,
Suddenly I heard a knock upon my door,
Only this, and nothing more.
Then I felt a queasy tingling and I heard the cash a-jingling
As a fearsome banker entered whom I'd often seen before.
His face was money-green and in his eyes there could be seen
Dollar-signs that seemed to glitter as he reckoned up the score.
"Cash flow," the banker said, and nothing more.
I had always thought it fine to show a jet black bottom line.
But the banker sounded a resounding, "No.
Your receivables are high, mounting upward toward the sky;
Write-offs loom. What matters is cash flow."
He repeated, "Watch cash flow."
Then I tried to tell the story of our lovely inventory
Which, though large, is full of most delightful stuff.
But the banker saw its growth, and with a might oath
He waved his arms and shouted, "Stop! Enough!
Pay the interest, and don't give me any guff!"
Next I looked for noncash items which could add ad infinitum
To replace the ever-outward flow of cash,
But to keep my statement black I'd held depreciation back,
And my banker said that I'd done something rash.
He quivered, and his teeth began to gnash.
When I asked him for a loan, he responded, with a groan,
That the interest rate would be just prime plus eight,
And to guarantee my purity he'd insist on some security-
All my assets plus the scalp upon my pate.
Only this, a standard rate.
Though my bottom line is black, I am flat upon my back,
My cash flows out and customers pay slow.
The growth of my receivables is almost unbelievable:
The result is certain-unremitting woe!
And I hear the banker utter an ominous low mutter,
"Watch cash flow."
Herbert S. Bailey, Jr.
Source: The January 13, 1975, issue of Publishers Weekly, Published by R. R. Bowker, a Xerox company. Copyright 1975 by the Xerox Corporation. Credit also to aridni.com.